Mandatory Savings Programs

"Low-income insurance simultaneously addresses all of the standard justifications for government intervention in private savings and retirement decisions."

In recent years, criticism of Social Security has escalated enormously. In part this reflects Social Security's impending insolvency; under current law, the Social Security Trust Fund is likely to be exhausted by mid-century. But more fundamentally, economists and others have highlighted a range of negative effects due to Social Security. These include the distortion of labor markets caused by high rates of taxation and the arbitrary redistributions both within and across age cohorts that inevitably arise in a Pay-As-You-Go system. On top of all this, Social Security is a complicated and costly system to administer.

In response to these problems, many critics have advocated the privatization of Social Security. This means that participants would have portions of their income withheld and deposited in standard saving vehicles, such as stock or bond mutual funds, rather than having these monies paid as taxes into the Social Security Trust Fund. At the same time, the promises of Social Security benefits in retirement would be eliminated; instead, retirees would consume out of the savings accumulated in their private accounts.

In other words, privatization means both the elimination of Social Security and the creation of a mandatory savings program. Thus, privatization as that term is currently being used does not end government intervention in savings and retirement decisions; it instead accepts a government role in dictating minimum savings rates, setting an age at which such savings can be withdrawn to fund retirement, and limiting savings choices to particular savings vehicles.

Yet the justifications for government intervention in savings and retirement decisions are not compelling. To the extent there is a role for government, mandatory savings programs (not to mention Social Security) are far more interventionist than economic analysis suggests is necessary. The arguments for a government role suggest instead that the maximum desirable intervention is narrowly targeted, low-income insurance.

The Arguments for Government Intervention in Private Savings Decisions

The standard justification for government intervention in private savings and retirement decisions relies on the assumption that some persons behave myopically, consuming "excessively" during their earnings years and then finding themselves with insufficient savings in retirement. There are no doubt some myopic persons, but this does not by itself justify intervention. Economists typically assume that government should intervene only when private actions adversely affect others—cause externalities—but the direct costs of myopia are borne by the myopic. Thus, to justify government intervention one must either believe that government should act paternalistically—protect people from themselves—or argue that myopic behavior spills over onto others.

The problem with the paternalism approach is that it can be applied in a broad range of contexts. In the name of protecting people from themselves, governments might ban certain books, outlaw foods with saturated fat, mandate exercise and sleeping schedules, or prohibit "bad" television and myriad other activities. It is possible that some persons would benefit from certain paternalistic policies, but the potential for benevolent paternalism to evolve into totalitarian government is obvious. Even if one puts aside such concerns, paternalistic policies typically penalize responsible persons in the name of helping the myopic.

An alternative argument is that myopic behavior in fact imposes externalities if society cannot restrain itself from bailing out those whose myopic behavior leaves them in dire straits. The magnitude of this effect is usually overstated. In the absence of government policies to aid the profligate, there would be private mechanisms to aid many of these persons. For example, charities and relatives helped many such persons in the era before Social Security, just as they now help those in countries without government safety nets.

Most importantly, myopia does not justify creating a mandatory savings program. The goal of helping the myopic can be accomplished with a low-income insurance program. Such programs use funds from general revenues to provide a minimal income to those beyond a certain age. By so doing, these programs both protect the profligate against the effects of their myopia and insure that everyone contributes to helping such persons.

A second possible justification for government intervention in savings and retirement decisions is that low-income persons cannot save enough for their retirement because their income during working years must be spent entirely on necessities. There are certainly some persons in this category, but again low-income insurance is a far better targeted response than a mandatory savings program. Indeed, for persons who cannot easily save for retirement, mandatory savings programs are a particular burden since they reduce disposable income during working years.

The third standard justification for government intervention in savings and retirement decisions is that, even in the absence of myopic or low-income households, some people experience bad luck and see their wealth fall drastically near retirement. Since these risks are significant at the individual level but far smaller at the aggregate level, society can reduce these risks by sharing them across individuals. Again, private mechanisms can mitigate this problem: by saving intelligently, purchasing life, medical, and accident insurance, and relying on relatives or charities, most persons can protect themselves against the worst-case scenarios. But even if this is not the case, policy can address this problem via low-income insurance; nothing as expansive as a mandatory savings program is required.

The Negative Consequences of Mandatory Savings Programs

Mandatory savings program are not only more expansive than required; they have substantial negative consequences. To begin, mandatory savings programs dictate that everyone save at the minimum rate or above even though for some households optimum savings rates will be lower than the mandated minimum. Examples include

persons who expect to work longer than average rather than retiring early,

those who know their kids will care for them in retirement,

or those who expect a big inheritance.

This problem can be ameliorated by making the mandated savings rate sufficiently low, but if a mandatory savings program rarely binds, it makes no sense in the first place.

Even if the mandated savings rates are approximately right for most persons, mandatory savings programs also dictate that savings rates are the same every year. This requirement is likely to harm a broad range of households. Consider a family attempting to accumulate the down-payment on a house. During the early years of working life, the sensible strategy is to use liquid assets that can be readily converted to cash at the time of house purchase. Yet if these earners are forced to save via the mandatory savings accounts, those funds are not available for a down-payment. Alternatively, consider an aspiring entrepreneur who wishes to invest all her savings in a small business. This person is constrained from using the funds in the mandated savings accounts even when the small business is a better investment. And anyone who suffers an accident or medical emergency might want access to some of his mandated savings.

A different distortion caused by mandatory savings programs is that they limit the set of savings vehicles to standard, relatively safe instruments such as broad-based mutual funds. Such vehicles are sensible choices for many persons, but for others it is appropriate to take additional risks, such as investing in one's own business.

And there many further problems with mandatory savings programs. Accumulations in the "private" accounts are tempting targets for taxation. The implied promise of retirement income gives government an additional excuse to regulate "risk" in financial markets. Mandatory savings programs promote an economy-wide retirement age, despite the fact that length of productive life varies widely. Plus, such programs have substantial administrative costs.

Beyond these tangible negatives of mandatory savings programs, there is a crucial intangible effect of establishing a government program that says, in effect, every household in the country is incapable of making sensible savings and retirement decisions. By so doing, society strengthens the presumption that people should rely on government to make decisions for them, rather than taking responsibility for their own well-being.

Low-Income Insurance is not Perfect, But It's Better

The claim here is that low-income insurance simultaneously addresses all of the standard justifications for government intervention in private savings and retirement decisions. Low-income insurance guarantees a minimum income in retirement for those who undersave; it protects those with low earnings; and it provides insurance against bad luck. In addition, low-income insurance for the elderly already exists in the form of Supplemental Security Income, the federal program that provides low-income insurance for those elderly not eligible for Social Security. Thus, no new bureaucracy need be created.

This does not mean that low-income insurance is problem-free. It requires sufficient taxation to pay the guaranteed income, and this taxation is likely distorting. And if the guaranteed level of income is too high, such insurance will induce substantial numbers of households to reduce their work effort so as to qualify for the guaranteed income. These considerations suggest that the income guarantees must be modest. So long as this is the case, any distortions caused by the taxation will be modest, as will the disincentive effects on labor supply. And most mandatory savings plans include low-income insurance for the poorest savers, so those costs are a given in any case. Most importantly, by limiting government intervention to low-income insurance, policy can avoid the additional negative consequences of mandatory savings programs.

In addition, the message society sends by operating a low-income insurance program is very different than that sent by operating a mandatory savings program. For all but the very poor, the message is that people must live with the consequences of their actions, even if these are unpleasant. It is true that some persons will take advantage of a low-income insurance program, even if the level of guaranteed income is low; that is indeed a cost of such a program. But at least this approach is the minimal intervention necessary to accomplish the stated objective of helping the myopic, the poor, or the truly unlucky.

Is a Mandatory Savings Program Necessarily Better than Social Security?

Many advocates of Social Security privatization accept the critiques of mandatory savings plans described above. They nevertheless advocate privatization because they fear it is politically infeasible to eliminate Social Security and because they believe a mandatory savings plan, with all its warts, is better than Social Security.

But even that conclusion is debatable. The comparison between a mandatory savings program and Social Security depends not just on the basic differences in structure but on the degree to which either program distorts economic decisions. By phasing in a higher age of eligibility and means-testing of benefit receipt, Social Security's ill effects on the economy could be reduced substantially while simultaneously converting Social Security into low-income insurance. The bottom line, therefore, is that for those who wish to eliminate the negatives of Social Security, the most natural goal is to phase it out, not to replace it with a mandatory savings program.

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